Abstract
This study examines whether reported values for firms’ research and development (R&D) affect analysts’ annual earnings forecast revisions following quarterly earnings announcements. Because R&D introduces uncertainty into earnings forecasts, analysts may benefit from additional information searches in an effort to increase forecast accuracy. Also, accounting standards mandate an immediate expensing of R&D, in essence projecting a zero value for the R&D. To the extent that R&D will produce future payoffs, the expense treatment reduces the informativeness of reported earnings for forecasting future earnings. Thus, the marginal benefit of analysts’ efforts to produce more information may increase with the magnitude of the R&D component of earnings announcements and trigger additional forecast revisions. Alternatively, if the cost of information searches exceeds the benefit, analysts’ forecast revisions may decrease.
Our results show a positive relation between R&D expenses and analysts’ forecast revision activity. We also find a positive and significant association between the level of R&D expenses and the magnitude of analysts’ forecast revisions following quarterly announcements. These results point to a greater amount of analyst scrutiny when reported earnings are accompanied by high levels of R&D expenses.
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Notes
For example, the June 30, 2005 FASB Exposure Draft “Business Combinations, a Replacement of SFAS 141,” calls for recording purchased in-process research and development acquired in a business combination as an asset, not an expense as currently required.
We use total operating expenses as the deflator to be consistent with Barth et al. (2001) and Barron et al. (2002). Alternatively, we employ sales as the deflator and the pattern of results is unaltered. Following Barth et al. (2001), we also use an industry-adjusted R&D ratio to measure a firm's R&D expense. Specifically, the industry-adjusted R&D ratio for a firm is calculated as the ratio of R&D expenses to total expenses for the firm, less the respective industry median ratio. The results based on this alternative measure of R&D expense are essentially the same as those reported in this study.
This study's main purpose is to examine analysts’ revisions of annual earnings forecasts in response to quarterly earnings information. Because 4th quarter earnings and annual earnings are usually released simultaneously, we exclude them from our sample.
Stickel (1989) reports a positive relation between analyst forecast revision activity and the sign of unexpected earnings. However, our sample differs from Stickel's by time period (Stickel 1982–1985, ours 1990–1999) and database (Stickel used 1,251 firms from Zachs with 7,526 total earnings announcements and we used 1,438 firms with 16,891 earnings announcements listed on I/B/E/S)
We use the Belsley et al. (1980) approach to assess the degree of collinearity among independent variables. The maximum condition index in all analyses is 11.38. Belsley et al. (1980) suggest that mild collinearity is diagnosed if the maximum condition index is between 5 and 10 and severe collinearity exists for an index over 30. Although there is some degree of collinearity in our multiple regression analyses, it does not appear to be a severe problem.
We also examine the forecast revision activity during the 10-day period before the earnings announcement and its association with R&D expense. Since we focus on the period prior to the announcement, both ABUE and SIGN are not relevant and we simply include DRD, SIZE, and VOL in the regressions. The results show that the coefficient on DRD is positive but not significant at the conventional level. A plausible explanation is that analysts tend to delay their forecast revisions until earnings information is released, making it less likely to find a significant association between R&D expense and revision activity before earnings announcements.
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Acknowledgments
The authors gratefully acknowledge Thomson Financial for providing earnings per share forecast data, available through the Institutional Brokers Estimate System (I/B/E/S) as part of a broad academic program to encourage earnings expectation research. We also acknowledge the valuable comments and insights provided by the conference participants at the 2004 American Accounting Association Annual Meeting. All errors are our own.
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JEL Classification: G14 · M41
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Ho, LC.J., Liu, CS. & Schaefer, T.F. Analysts’ forecast revisions and firms’ research and development expenses. Rev Quant Finan Acc 28, 307–326 (2007). https://doi.org/10.1007/s11156-006-0013-8
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DOI: https://doi.org/10.1007/s11156-006-0013-8